How China's Yuan Can Become a Global Currency

With the rapid economic ascent of China, the explosion of the global crisis, and the discrediting of the U.S. and European financial models, there has been growing speculation on the future role of China's currency, the yuan. Recent new policy initiatives adopted by Beijing toward its own currency and statements by senior officials of the People's Bank of China (PBOC) (who have recently become increasingly vocal in world forums on the need of economies to rely less on the U.S. dollar as a reserve currency and for trade settlement) have fueled the debate further.

What does it mean for a currency to be global? To gain international stature, there must be strong demand by world traders, investors, and central bankers for the currency as a medium of exchange for foreign trade settlement, a unit of account for denominating international financial transactions, and a store of value for central banks' foreign exchange reserves. Economists generally agree there are three pillars for the internationalization of a currency: the size of the country's economy and its trade volume; the breadth, depth, and liquidity of its capital markets; and the stability and convertibility of its currency.

China certainly meets some of those criteria. In terms of economic strength, China's breakneck growth rate since the beginning of the 21st century has helped the country surpass Germany and become the world's third-largest economy. Only the U.S. and Japan are larger. Goldman Sachs (GS) has projected that China will overtake the U.S. to become the world's largest economy by 2027, should China manage to continue to grow at its current rate.

Population Still in Penury However, a large gross domestic product is not necessarily equal to a wealthy or healthy economy. Despite its No. 3 world ranking in absolute economic size, China remains far behind the other leading economies in average per capita income level. In the long run, even though China's GDP per capita is projected to surge exponentially, to $49,650, by 2050, up from $2,430 in 2007, it will still lag far behind that of the U.S. ($91,683) and many other developed and emerging economies, according to Goldman Sachs.

Furthermore, despite optimistic projections of China's future growth potential, its economy is still beset by numerous imbalances and risks in the medium term. These include, among other problems, persistent and widening regional economic disparities and rural-urban income inequality, rising social unrest and inter-ethnic conflicts, rampant corruption, and serious environmental degradation. An eruption of any one of these, or a combination of several "fault lines," could put a sharp brake on the ascent of the Chinese economy and concomitantly propel the yuan onto an inordinately volatile trajectory.

In terms of trade volume as a share of the world total, China's ratio was 5.1% in 2007, having already overtaken Japan and Britain in 2004. In the first half of 2009, the World Trade Organization reported that China had surpassed Germany to become second only to the U.S. among the world's largest exporting nations.

Accompanying the surging foreign trade is the expanding trade settlement by the yuan, which has already evolved into a major currency for cross-border trade settlement with neighboring countries such as Cambodia, Mongolia, Russia, and Vietnam. At the end of 2008, the Chinese government announced pilot programs allowing Guangdong province in southern China and the Yangtze River Delta in the eastern part of the country to use the yuan to settle trade deals with Hong Kong and Macao. A similar arrangement is under consideration to allow southern Guangxi and Yunnan provinces to use the yuan to settle trade accounts with select member-countries of the Association of Southeast Asian Nations (ASEAN). Another recent and significant step is the announcement by the State Council designating five trial cities—Dongguan, Guangzhou, Shanghai, Shenzhen, and Zhuhai—to spearhead international trade settlement in the yuan with overseas counterparties.

Pushing to Raise the Yuan's Profile Moreover, in order to mitigate exchange-rate risks arising from trade settlement in the dollar, China has entered into bilateral currency-swap agreements with a number of trading partners. Since December, the PBOC has signed a total of 650 billion yuan worth of currency-swap agreements with Argentina, Belarus, Hong Kong, Indonesia, Malaysia, and South Korea. The PBOC is in talks with other central banks to ink additional swap agreements and is likely to expand them to cover all of the country's trade with Asia, excluding Japan. Such recent progress signals that the Chinese government is beginning to set the yuan on a liberalization path, starting with a gentle push of the unit to raise its profile as a medium of exchange in its regional backyard.

Aside from innate economic strength, the home country of an international currency should offer open and sophisticated transaction venues where foreign dealers can trade a range of the currency-denominated financial products, while at the same time put in place regulatory and macroeconomic safeguards to minimize the unit's volatility and exchange-rate-related risk.

Compared with other more developed capital markets elsewhere, it is clear that China's capital markets are still at an early stage, and they may take one to two decades to develop into comparable breadth and depth. By global standards, China has lower equity and bond market capitalizations to GDP ratios relative to that of issuing countries of major currencies. Furthermore, despite a banking sector as large as 9.1% of total global bank assets, China's equity and bond market capitalizations only make up 5.9% and 2.4% of the world's equity and bond markets, respectively, according to Deutsche Bank Research.

Second, because of regulatory barriers restricting access to its capital markets, China's interaction with foreign markets and openness to the rest of the world are still very restricted. In terms of inward portfolio investments to China, the average amount between 2003 and 2007 represented a mere 0.7% of total portfolio investments globally. As of mid-2009, only 87 foreign financial entities were entitled to Qualified Foreign Institutional Investor (QFII) status, which allows them to trade A-shares on secondary markets with an aggregate limit of not more than $30 billion, or just 1%-2% of the Shanghai exchange's market capitalization. Furthermore, the purchase of B-shares is also limited to a select group of foreign institutional investors, and Hong Kong-listed H-shares are but a fraction of the two mainland markets.

Third, low efficiency, high transaction costs, and weak supervisory and regulatory frameworks have been major constraints to the integration between China's capital markets and the international financial system. As for equity issuance, China still practices a merit-based approval system in comparison with registration-based systems in most mature capital markets overseas. According to a comparison of financial transaction costs done by the China Securities Regulatory Commission (CSRC), the Shanghai and Shenzhen stock exchanges have an average cost of 50 basis points (with 20 as the average commission and 30 as the transaction fee). That's more than double the average of 21 in most mature markets. As for bond transaction costs, China has an average basis point of 6.3, dwarfing 1.0 in Britain, South Korea, India, and Singapore; 0.4 in the U.S.; and 0.5 in Japan. In view of the increasing competitiveness among world financial markets, the current bureaucratic supervisory system in China needs to be reformed to a more professional framework by international standards, and transaction costs also need to be reduced substantially.

Early Stages Nevertheless, some progressive steps have been initiated recently to add more breadth and depth to China's capital markets. These include regulators' latest announcements of plans to allow qualified foreign-invested firms to list on the Shanghai exchange next year, raise the investment limit per QFII to $1 billion from $800 million, and approve foreign banks to issue yuan-denominated corporate bonds. Likewise, in an unprecedented move, the Finance Ministry unveiled in September that in order to "promote the yuan in neighboring countries and improve the yuan's international status," it would help establish an offshore yuan bond market by starting to sell $879 million worth of yuan-denominated sovereign bonds in Hong Kong to foreign institutional and retail investors.

Despite these encouraging moves, it will take some years before China's capital markets can successfully transit to a more open and mature stage. According to the development strategies published by the CSRC in 2008, China will need roughly a decade to undergo "the drive to maturity stage" and build up well-developed capital markets. This would render full yuan internationalization unlikely before 2020.

Apart from the aforementioned "physical" factors fundamental to the internationalization of a currency, other "psychological" factors such as public confidence in the value of the currency also play a supporting role. Empirically, the stability of a currency can be gauged by its home economy's inflation rate, which for China averaged just 1.1% per annum from 1998 to 2007. A second way of assessing currency stability can be measured by the unit's exchange-rate volatility, which can be calculated as the standard deviation of daily percentage change in the exchange rate against the IMF's Special Drawing Rights (SDRs). Our calculation yields a score of 4.4 for the yuan during this period—lower than those of the dollar (4.5), euro (5.4), or yen (8.2).

However, despite its low volatility, the yuan lacks the foremost prerequisite to becoming a global currency: free and full convertibility. While the yuan became convertible for trade transactions and conditionally for foreign direct investment (FDI) in 1994, it has been largely nonconvertible for all portfolio capital transactions till now. Nevertheless, recent policy initiatives taken by the government have demonstrated the likelihood of a faster pace toward capital account convertibility. According to Guo Shuqing, former head of the State Administration of Foreign Exchange, the yuan would be convertible by 2010 for about 70% of the 43 capital transaction items under the IMF classification.

While chances are good that the yuan will evolve into a regional currency in the next few years, China is in no position to challenge the preeminent role of the U.S. dollar in the near future, despite some worries in the U.S. prompted by comments from Chinese Premier Wen Jiabao and others. In addition, out of concern for political, economic, and social stability, the Chinese government has adopted an extremely cautious approach toward financial liberalization. Therefore, it is not a sure conclusion that the government would have the political will to push forward aggressive reforms in capital markets, even though it has recently shown some interest in using the yuan for trade settlement. Furthermore, politically it is also not certain whether other countries would have the confidence to accept the yuan for various international uses, a currency issued by a country controlled by a Communist Party.